Personal Residence Trusts
No asset is more important to shield from creditor claims than the house we live in. For most of us, the house represents the bulk of our fortune. It may also have great sentimental value.
The personal residence trust is the most commonly used structure to protect a home. This is a structure that is inexpensive to set up, simple, and exceptionally effective. Over the course of our careers we have established hundreds of these trusts for our clients. They have never failed to achieve their desired objective. Let us take a look at how these trusts work.
A personal residence trust is an irrevocable trust. The word "irrevocable" scares many people. None of us want to do anything that is irrevocable, especially when we are talking about our most significant asset.
Fortunately, irrevocable simply means that no one (like a plaintiff or a creditor) would be able to force you to revoke the trust. You will always be able to do so, and quite easily, without going to court. For example, under California law there is an easy procedure to revoke an irrevocable trust that just requires the trustee of the trust and the beneficiary to sign a simple document.
Because the trust is irrevocable, the assets owned by the trust are not owned by you. At least not in the legal, technical sense. The trust now owns your home. Because you no longer hold legal title to the house you live in, it is not an asset that your creditor can reach. Your legal relationship with the house you live in becomes the same as your legal relationship to the Transamerica building in San Francisco. It is not your asset, and when you get sued, your creditor cannot attach either one.
The residence trust allows you to continue living in the house, rent free, usually for the rest of your life (technically, this period of time is measured in a specified number of years tied to your life expectancy). Your children or other family members would then become the beneficiaries of the trust. This structure is very similar to your living trust.
There are no income tax consequences on the transfer of the house into the residence trust. There are no property tax consequences and no property tax reassessment. Your bank cannot accelerate the mortgage (there is a federal statute that prevents the bank from doing anything with your mortgage when the ownership of the house is transferred to a trust).
Because the trustee of the trust will be a person you appoint (usually a friend or family member, but never you), you will retain the ability to sell the house or to refinance the house. Additional flexibility can be built into the trust to accommodate your specific needs.
The trust is not subject to any annual fees or filing requirements. Once it is done it is done.
To summarize, the residence trust is an inexpensive, easy to establish structure that allows you to continue living in your house, allows you to retain control over your house, but at the same time makes it unreachable to creditors (which has been tested in practice time and time again). It is no wonder that these trusts are our favorite asset protection technique for a personal residence.
Beware! Limited liability companies and limited partnerships are easy to set up, but they are not easy to set up correctly. While any limited liability company or limited partnership will provide you with some degree of asset protection, only a properly structured one will offer you the maximum asset protection possible. Proper structuring requires tax and asset protection expertise. Our limited liability company and limited partnership agreements include such sophisticated devices as distribution freezes, automatic removals, poison pills, buy-out rights and other.
Limited Liability Companies &
Limited Partnerships
Limited liability companies and limited partnerships are frequently used in asset protection. Consider the following.
Any asset that you own (the asset is titled in your name or owned by you directly) can be seized by a creditor. For example, if you have an apartment building or a bank account, a creditor can seize those assets. Any asset that you do not own cannot be taken from you by a creditor. While that sounds like a simplistic statement, it lies at the heart and soul of asset protection planning.
Any asset that is owned by a legal entity is not owned by you, even if you own and control the legal entity. For example, if you own a share of General Motors, you have no ownership in GM's assembly plant in Detroit. This concept applies to any legal entity, regardless of the percentage of the entity you own.
How does that benefit you? Once you transfer the ownership of an asset to a limited liability company or a limited partnership, you no longer own that asset. The asset is now owned by the LLC or the LP. All you own is an interest in this legal entity. So, why is it better to own an interest in a legal entity than to own the underlying asset directly?
Under the laws of all states, interests in limited liability companies and limited partnerships are protected by the so-called charging order protection. Pursuant to the charging order protection, a creditor cannot seize your interest in one of these entities. And if they cannot take your interest in the entity, they cannot get to the underlying assets. For a more in-depth study of charging orders, click here.
Note, corporations do not offer you any charging order protection. If you own a corporation, which in turn owns valuable assets, a creditor will be able to seize your corporate stock, and then get to the valuable assets. Corporations will only protect you from lawsuits directed against the corporation itself. If the lawsuit is directed against the shareholder, there is no protection. If you are seeking to protect assets from claims of creditors, forget about corporations. Look into forming a limited liability company or a limited partnership.
Assets that our clients commonly protect by using limited liability companies and limited partnerships include investment and income producing real estate, intellectual property, valuable businesses, corporations, art and collectibles, airplanes, and other valuables.
By appointing you as the manager of the LLC we allow you full control over your assets, without compromising asset protection. All entities are structured to be tax neutral - this means that there will be no tax consequences to you in setting up a limited liability company or a limited partnership. Most of the time, these entities can be structured so that they will not even have to file federal income tax returns. For state income tax purposes, there are usually no returns to file, but this requirement does vary from state to state and you should consult with your attorney or CPA.
Limited liability companies and limited partnerships are easy to set up, have nominal annual costs, and provide you with a tremendous level of asset protection.
Example: Dr. Brown owns Apartment Building 1 and Apartment Building 2. Building 1 is owned through a corporation and Building 2 is owned through a limited partnership. Assume that a tenant in each building slips and falls and files a lawsuit. Each tenant would have to sue the owner of the respective building, which means the corporation and the LLC. Each legal entity will protect Dr. Brown and prevent the lawsuits from reaching his personal assets. Great result.
Now assume that Dr. Brown runs over a pedestrian and is being sued personally. The plaintiff obtains a judgment against Dr. Brown and looks for Dr. Brown's assets to pursue. What happens to the apartment buildings?
While the creditor would not be able to seize Building 1 directly, the creditor would be able to seize Dr. Brown's corporate stock, then liquidate the corporation and get to Apartment Building 1. Not a good result.
With respect to Apartment Building 2, the creditor will not be able to get Dr. Brown's interest in the LLC, and will not be able to get Apartment Building 2. Great result.
Equity Strips
Whether you are looking to protect a personal residence or investment real estate, you have to realize that creditors do not pursue the real estate itself, but the equity in the real estate. Creditors have to foreclose on the real estate, which means the real estate will be sold by a sheriff. On the foreclosure sale, after the payment of secured liens (like a bank mortgage), after paying the sheriff's expenses, and after paying to the debtor the homestead exemption amount, the remaining equity goes to the creditor. Consequently, it is the equity that gets converted into money and given to the creditor. Not the real estate itself.
If the real estate has no equity, then on a foreclosure sale the creditor will not get any money. For example: Your home is worth $1,000,000 and is encumbered by a mortgage of $800,000. You live in California and your homestead exemption is $75,000. The home is forced into a foreclosure sale, where it is sold to some buyer for $900,000. Of the $900,000, the first $800,000 goes to the bank to pay off the mortgage. Then some money goes to the sheriff, and then $75,000 goes to you. There is nothing left for the creditor.
An intelligent creditor can do this math ahead of time and will not try to push a home like this into foreclosure. As a matter of fact, many creditors will drop their lawsuit if they realize that there is no equity left to pursue. Consequently, many debtors look to eliminate (strip out) their equity.
There are two equity stripping techniques:
Actual Bank Loan
One way to strip out the equity is by obtaining a bank loan. The bank will secure the loan by recording a deed of trust against your property. This eliminates the amount of equity equal to the loan.
While this technique results in the elimination of equity, there are two problems. First, it is difficult to obtain a bank loan large enough to eliminate 100% of equity. Second, the cost of this asset protection technique is staggering. Assuming a $1 million loan bearing a 7% interest rate, the cost of this equity strip is $70,000 per year. (Debtors usually ameliorate the carrying costs by investing the loan proceeds at a comparable rate of return.)
Paper Strip
Another way to strip out the equity (frequently advocated by debtors), is to encumber the residence by recording a deed of trust in favor of a friend.
This avoids the carrying costs of an actual bank loan and can be done in any amount. With this technique it is important to know the intelligence and the aggressiveness of the creditor. Some creditors may stop trying to collect when they realize that there is no equity in the residence. Others may dig deeper, and if the debtor cannot substantiate the transaction as an actual loan, the deed of trust will be set aside by a court as a sham. The creditor will again have equity to pursue.
Sale to Friendly Third Party
Many debtors consider selling their residence to protect the equity. However, they may not want to actually move out. To accommodate these conflicting desires, the sale and leaseback of the residence to a friendly third-party on a deferred installment note may be the solution.
Under this structure, the debtor sells the residence to a friendly party and takes back a promissory note. The promissory note is usually structured as a long-term balloon note. The debtor then leases the property back from the buyer and continues to live in his old house. Instead of owning a house, the debtor now owns a promissory note, an asset that is a lot less desirable to a creditor.
This structure works only so long as the debtor can establish the legitimacy and the arm's-length nature of the sale. Income tax consequences of the sale, and possible property tax consequences on the transfer of ownership should be considered.
Outright Sale
An arm's-length cash sale is the best way to protect the residence (and the equity in the residence) because it is much easier to protect liquid assets (sale proceeds) than real estate. While this technique affords the best possible protection, it is also the most radical and may result in additional income taxes.
Foreign Entities
Limited liability companies are a fantastic asset protection tool. You can read more about LLCs and their asset protection benefits here. Why do foreign entities (sometimes referred to as offshore entities) warrant special attention?
Foreign entities may, at times, a viable alternative to foreign trusts as a mechanism to protect liquid assets. Foreign trusts allow you the most protection imaginable, usually, unbreakable protection, but they are not the cheapest alternative around.
Some clients do not want to go through the expense or the trouble of a foreign trust, or may simply not need that much protection. A foreign trust may be overkill in some cases.
Holding assets in your name directly also does not work. As a general rule, any asset that is owned by you directly (titled in your name) can be taken from you by a creditor. It does not matter whether this asset is stock of a corporation or a foreign bank account. All assets, domestic and foreign, owned by you directly can be reached.
One of the few exceptions to this rule is an interest in an LLC. All LLCs are shielded by the charging order protection. What is then the difference between a domestic (U.S.) LLC and a foreign LLC?
Simple. A foreign LLC is governed and protected by the laws of a foreign jurisdiction. This means that it may be possible to move any litigation surrounding a foreign LLC to a foreign country. This makes it very expensive for the plaintiff to pursue a foreign LLC. Not impossible, but expensive.
Sometimes all we need to do is change the plaintiff's or the creditor's economic analysis. Destroy their profit potential and they will leave you alone.
All entities, especially foreign entities, may have tax consequences. You should consult with your advisors and implement these strategies very carefully.
Foreign Trusts
The term "foreign trust" means an irrevocable trust governed by the laws of a foreign jurisdiction. Foreign trusts are similar or even identical in most respects to the standard trusts that we all see every day. The main difference is the governing law. If the trust provides that it will be governed by the laws of California, then California trust law will apply. If the trust provides that it will be governed by the law of the Cayman Islands, then those laws will govern the trust. When we draft the trust we get to pick the governing law by simply drafting it into the trust.
Several foreign countries have enacted trust laws designed to assist debtors with asset protection. The laws of these countries go through every step possible to make it impossible for a plaintiff to pursue the assets of a foreign trust.
These foreign countries erect the following obstacles in the creditor's path: (1) They will not recognize a legal judgment from any other country, including the U.S. This means that the judgment obtained against you by your creditor here in the U.S. is meaningless. (2) Because the creditor's attorney is not licensed to practice law in that foreign country he would have to hire local attorneys to litigate for him, which is an expensive proposition. (3) The trustee of the foreign trust is a trust company that has no connections to the U.S., which means that a U.S. judge will not be able to force the trustee to distribute trust assets to the plaintiff.
The assets transferred to a foreign trust are usually liquid, such as bank accounts or brokerage accounts, but can also include intellectual property, interests in legal entities and other. The assets owned by the trust can be located anywhere in the world, including the U.S. or Europe. The assets are almost never held in the same country where the trust is set up. After all, who would want to keep their life-savings in a country like Vanuatu, which most Americans have never heard about.
Most of our client transfer the ownership of their assets to the foreign trust but keep the assets in the United States, with their existing banks or brokerage firms.
Often, foreign trusts are established in such a manner as to allow the client to be the only one who can know what assets are owned by the trust and to be the only one who can reach those assets. Even the trustee of the trust can be effectively prevented from having access to your assets. This way you don't need to worry that anyone will run off with them.
Over the years foreign trusts have become a favorite planning technique for many debtors. These structures are perfectly legal, tax neutral (while they usually have to be disclosed to the IRS, they are treated in the same manner as living trusts - ignored for income tax purposes) and extremely effective in protecting assets from lawsuits.
It should be noted that many debtors believe that simply moving money to an offshore bank account will serve as sufficient protection from creditors. While the plaintiff may have a difficult time enforcing his judgment in a foreign country and levying on a foreign bank account, the debtor will never have a problem withdrawing the money if the account is directly in the doctor's name. Consequently, the plaintiff may petition the court to direct you to withdraw the money from your foreign account and to pay it over to the plaintiff. With a foreign trust that can never be a problem, because you will not be the legal owner of the assets of the trust.
